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Interviewed on CNBC Wednesday, UBS’s Art Cashin, a great market historian, indicated that in years that end in “7”, market declines have often begun in August’s first three weeks. I explored that claim for the Dow Jones averages back to the Dow’s initiation in the 1880s. Hand-drawn daily graphs produced by the late Richard Russell of Dow Theory Letters fame were my data source, so percentages are approximate. Notwithstanding the lack of any logic for such a number-related pattern, the results are interesting. Make of them what you will.

1887

12 stock average (10 railroads, 2 industrials) An approximate 5% decline through the second half of August was simply a continuation of a 17% decline from May to October.

1897

New 12 stock industrial average – A consistently strong August followed immediately by an 18% drop from early-September into November.

1907

A significant 11% early-August decline was merely another step down in the 45% “Panic of 1907” which extended from January into November.

1917

New 20 industrials, initiated in December 1914 following the multi-month market holiday – August’s 12% decline from the first week high covered the rest of the month and simply contributed to the 33% decline from January into mid-December.

1927

A slightly greater than 4% decline marked two weeks in the beginning of August, but the powerful 1920s rally resumed in mid-month on its way to the historic 1929 peak.

1937

Mid-August marked the beginning of the 1937 crash, which saw the index plunge by 40% into November. Markets bounced around for the next five years with a downward bias. Down 52% from the 1937 high, a great bull market began in 1942 that lasted into the 1960s with only relatively minor disruptions.

1947

Pretty consistent small declines in August comprised the bulk of a greater than 6% total decline that began in late-July and continued into September.

1957

Prices dropped sharply through most of August as part of the 19% decline that extended from mid-July into mid-October.

1967

A 3% to 4% August pullback interrupted the market’s rally to this year’s September high, followed by a 12% decline into 1968.

1977

Prices declined pretty consistently through August as a continuation of the 26% decline from the beginning of the year through February of 1978.

1987

The Dow Industrials peaked on August 25 and began the decline that culminated in the 508-point plunge on October 19. That 22.6% one-day decline is still by far the most destructive day in U.S. market history. The entire two-month decline from the August high came to 36%.

1997

An almost 8% decline covered most of the month of August as the initial stage of a 13% drop into late-October.

2007

From the second week in August, stocks dropped a sharp 6% in about a week, before rallying into an early-October peak. Over the next 17 months the Dow was crushed by 54%.

2017

?

Only one of the 13 profiled “7” years avoided at least a 3% decline at some point in the month. In 1897, prices marched steadily upward, but suffered an 18% decline shortly after the month ended.

1927’s 4% plus decline marked just a brief interruption of the Roaring ‘20s rally, which introduced the Crash of 1929 and the Great Depression. Similarly, in 1967 the relatively small 3% plus decline did not initiate a more significant retreat, but it was followed just a few weeks later by a 12% decline.

August of 1937 and 1987 marked the beginning of two of this country’s most destructive stock market crashes. And August 2007, while not initiating the 2007-2009 54% market collapse, issued a clear warning that stock prices were in danger. The ensuing decline took away 13 years of price progress.

None of this tells us what will happen in August 2017, but it does raise a caution flag.

Would you accept an 80% chance to earn 10% on your money if there were a 20% chance of losing 40%? Such percentages may or may not be precisely descriptive of the current situation in the equity market, but they frame the dilemma today’s investors face.

As we have discussed frequently over the past year, stocks are extremely overvalued by traditional measures of valuation. In fact, a composite of the most commonly employed measures of value show today’s stocks more overpriced than ever before but for the period of the dot.com mania. Should stocks suddenly revert to historically normal valuation levels, prices would plummet. On the other hand, our Fed and the world’s other major central bankers have resolutely prevented any significant stock or bond market decline for the past eight years. As long as investors stay confident that central bankers will remain both willing and able to support securities prices, investors accepting equity market risk can continue to profit.

What happens to equities is extremely important, because other asset classes have been non-productive for years and likely will remain so over the near-term. While the Fed has begun to “normalize” its monetary policy by very tentatively raising short-term interest rates, risk-free investments still offer almost nothing. Because central bankers have aggressively poured newly created money into longer maturity fixed income securities, those yields have been suppressed for years. Nonetheless, interest rates have been rising, albeit slowly. Since interest rates bottomed in July 2012, the ten-year U.S. Treasury yield has risen from 1.39% to 2.30% at quarter-end. Total returns on such holdings have been barely 1% per year for almost five years. With the Fed and most analysts forecasting higher rates, returns on existing fixed income securities are likely to be minimal over the next several years as well.

We have long maintained that today’s investors are faced with making a “bet”. Will stock prices revert to their traditional valuation means, which they have always ultimately done, or will the Fed and other world central bankers continue to prevent significant declines in stock and bond prices, a task they have executed most effectively for the for the past eight years?

Investors who stay abreast of financial news and opinion have frequently heard analysts justify their forecasts of continuing price gains by pointing out that the economy is good, that corporate profits are growing nicely and that valuations are reasonable. Not one of these points is accurate.

The economy is growing, but very slowly. Despite more monetary stimulus than ever before, the domestic and world economies are slogging through the slowest recovery from recession in modern times. While there are intermittent spurts of growth in one economic segment or another, domestic and world economic growth is significantly below its historic norm. Notwithstanding optimistic consumer and investor sentiment, the International Monetary Fund, the Organization for Economic Cooperation and Development and the Federal Open Market Committee are forecasting minimal economic growth over the next few years. The majority of forecasters expect long-term U.S. growth to fall just above or below 2%–far below typical past levels.

The Bank for International Settlements has recently voiced serious concerns about downside risks. In the Bank’s 2017 Annual Report, head of the Monetary and Economic Department, Claudio Borio said: “[T]he risky trinity are still with us: unusually low productivity growth, unusually high debt, and unusually narrow room for policy maneuver.” Also “Leading indicators of financial distress point to financial booms that in a number of economies look qualitatively similar to those that preceded the Great Financial Crisis.”

Corporate profits of domestic companies showed significant growth in 2017’s first quarter on a year-over-year basis, largely because profits in the first quarter of 2016 were so heavily penalized by severe losses at major oil companies. Financial engineering has also magnified the appearance of corporate profits. Because companies are having a very difficult time finding attractive projects for which to make capital expenditures, they have borrowed heavily to buy back huge amounts of their outstanding shares. Reducing the number of shares outstanding has the effect of boosting earnings per share despite the overall level of company profits remaining constant. Since 2009, earnings per share have grown by 221% with corporate revenues up a mere 28%. And despite significant earnings per share growth, total corporate profits in 2016 were the same as in 2011. Over that same period of time, the S&P 500 rose by 87%. All is not what it seems.

Securities analysts and strategists have a habit of picking and choosing data that justify their almost always bullish conclusions. While almost no one contends that stocks are cheap, most commentators skip over discussions of valuation with a kind of off-handed remark that stocks are reasonably priced. The reality is that they remain screamingly overvalued. As mentioned earlier, by a composite of the most commonly employed measures of value, they are more overvalued than ever before but for the period immediately surrounding the dot.com mania. From lower levels of overvaluation, stocks declined by 89% from the peak in 1929, 45% from 1973 and 57% from 2007. From the peak of the dot.com bubble in early 2000, stocks fell 50% and, after a recovery and an even bigger decline, were 57% lower nine years later. Prices were back to 1996 levels, having erased 13 years of price change. From even lower levels of overvaluation, there are no examples of investors permanently escaping severe declines taking prices back to historically normal valuations.

Compounding the problems of a sluggish economy, moderate (at best) corporate profit growth and severe overvaluation is the unprecedented overindebtedness throughout most of the world. While economies and securities markets don’t fall simply because they are over-leveraged, that condition creates the environment in which even relatively small disturbances can quickly devolve into crises. We are currently on shaky ground.

Standing in the way of apocalyptic consequences is our Federal Reserve Board and other major central banks which have assumed as a mandate the prevention of anything more than minor price dips in either stock or bond markets. With monetary printing presses rolling more industriously than ever before over the past eight-plus years, they have warded off even normal price corrections, much less bear markets.

So confident are investors that central bankers will continue that support, they buy every dip. If that confidence remains strong, there is no upside limit to the current rally. Should that confidence wane, however, prices could seek more historically normal levels very quickly. By way of illustrating the danger, imagine all central banks suddenly pledging no more support in any form for stock and bond prices. The rush for the exits would be breathtaking, and exit doors would prove far too small. We could be faced with market holidays, as in 1914 or 1933. While central bankers are not going to suddenly swear off all support for markets, the level of investor complacency is unjustified in an environment of economic and monetary uncertainty and great geopolitical instability.

Last week provided a vivid example of the powerful forces currently influencing stock prices. On Monday and Tuesday, prices rose, reaching all-time highs on some market indexes. Despite underlying fundamental conditions that have historically corresponded with far lower valuation levels, short-term traders continued to buy even the smallest price dips. After more than eight years of financial stimulus from the Fed and other major world central banks, fear of market declines has virtually disappeared.

Then came news that ex-FBI Chief James Comey had taken contemporaneous notes of his conversations with President Trump that included a request from the President that Comey not continue the investigations of former National Security Advisor Michael Flynn. Stock prices gapped down by about 125 Dow points on Wednesday morning, reflecting fear that stepped-up investigations of alleged administration collusion with Russia could derail or at least seriously delay highly anticipated business-friendly Trump administration tax, deregulation and foreign money repatriation proposals. The buy-the-dippers largely stepped aside for the full day, and fear prevailed with the Dow closing at its low for the day, down 372 points. Volume increased substantially.

Selling pressure pushed Dow prices down another 50 points in Thursday’s early trade, but algorithms elevated prices off that low. One can only estimate the collective attitude of traders, but it would be logical to expect that sellers would stand aside to see if the early rally “had legs”. When no significant selling materialized after the morning rally, another “algo-like” advance took prices up again in mid-afternoon (New York time). Some selling came in in the last hour and a half, but the market closed up on the day.

No follow-through to Wednesday’s massive decline and some friendly comments by Fed Governor Jim Bullard gave traders the courage to make another run for the highs on Friday morning. The rally gained strength through the day until stories hit the newswires that 1) the President had told the Russian Foreign Minister and Ambassador in the White House that his firing of Comey had greatly eased pressure on him relative to the Russian investigation and 2) that an unnamed current senior member of the White House staff was a “person of interest” in the Russian collusion investigation. That news release cost the Dow about 75 quick points. Nonetheless, the market retained most of its strong gain for the day and closed the week down about 100 Dow points, less than one-half of one percent. That’s a relatively small decline given some significant volatility.

The week’s activity showed us a few things. Traders are still eager to push prices higher, and they retain a high degree of confidence that central bankers will continue to step in if danger of a significant market decline presents itself. At the same time, however, the market shows its nervousness about political news that could distract from the proposed legislative agenda or, worse, tie the country up in a vitriolic impeachment fight.

With valuations and debt levels in extremely dangerous territory, it is essential that investors retain their confidence if prices are to remain near record levels or to advance further. For investors with largely irreplaceable capital, the potential for negative surprises should dampen willingness to expose large portions of that capital to overvalued equities.

The first quarter marked a continuation of the behavior characteristic of the stock market and economy for the better part of the past several years. Stock prices sustained their post-election rally through the end of February, rising over 7% in the year’s first two months, then giving back a bit more than 2½ % to mid-April. At the same time, the economy has grown, but at an extremely sluggish pace.

Newspaper headlines and investment firm research trumpet the good news of increasing employment statistics and growing wages. More houses are being built and sold at increasingly higher prices. And economic growth is widespread, not restricted just to the United States. There is, however, a “but…” associated with each of these apparent positives.

Employment rolls are growing, and unemployment statistics are shrinking, but largely because millions of former workers have opted out of the labor force, many discouraged about job prospects. Wages are rising, but at a far slower pace than in prior economic recoveries. More houses are being built and sold, but the numbers are far below levels of a decade and more ago. These statistics look good only in comparison with the extremely depressed numbers that resulted from the Financial Crisis. And the global economy is growing, but at a rate only marginally above stall speed.

Add to these qualifiers slowing vehicle sales, sluggish consumer spending, stalling bank loan growth, declining individual and corporate tax receipts at the state level, and bond yields reflecting significant economic uncertainty, and there is good reason to question a bullish economic outlook. The Atlanta Federal Reserve Bank, which has issued the most accurate forecasts in recent quarters, has dropped its most recent forecast for GDP growth to just 0.5%, a barely perceptible rise.

According to Evercore ISI, improving stock and housing prices since the Financial Crisis have raised household net worth relative to disposable income to an all-time high in this country. Logically, more wealth in the pockets of potential investors and consumers should bode well for tomorrow’s stock market and economy. Ironically, in the 70 years of this study, the only two prior instances that approached today’s wealth level marked the stock market and economic peaks following the dot.com and housing bubbles. Those peaks preceded serious recessions and declines that cut stock prices by more than half.

Since the election, consumer, executive and investor surveys have displayed remarkably strong levels of optimism. Such surveys are called “soft data.” Unfortunately, “hard data” (real economic results) have been coming in surprisingly weak. In fact, in recent years, there has never been a disparity this great between hard and soft data. It brings to mind Warren Buffett’s famous line that in the short run the market is a voting machine, but in the long run, a weighing machine. Bullish attitudes have “voted” stock prices higher, but “weighing” fundamental conditions could result in far lower prices.

Because corporate earnings were so depressed in the first quarter of 2016, largely because of oil price weakness, analysts expect to see a significant –possibly double digit– jump in this year’s first quarter results. Earnings per share (EPS), however, have become increasingly deceptive over the past several years. Since 2009, corporate EPS are up 221%, the sharpest post-recession rise in history. Corporate revenues, however, have increased by just 28% in the same period. TheWallStreet Journal accused corporations of “…clever exploitations of accounting standards that manage earnings to misrepresent economic performance.” Share buybacks, which have become commonplace in recent years, increase EPS without companies increasing overall corporate profit. Total corporate earnings, not EPS, through the fourth quarter of 2016 were at 2011 levels despite the S&P 500 having advanced by 87%. The only thing that has soared has been the price-to-earnings (PE) multiple. Over many decades, periods of PE multiple expansion have been followed cyclically by multiple contraction. The current cycle of year-over-year multiple expansion has lasted 57 months, the longest on record. The two prior longest cycles ended in 1987 and 2000 with two of the U.S.’s most devastating stock market crashes. Excesses are inevitably followed by reversion to the mean.

As I have explained repeatedly in recent quarters, despite minimal economic progress, stock prices have been boosted mightily by the historic levels of monetary stimulus provided by the Federal Reserve and other major world central banks. That stimulus has extended well beyond traditional interest rate and money creation measures. As early as 2014, Financial Times reported that central banks, especially the People’s Bank of China, had bought more than $1 trillion in equities. In more recent years, the Bank of Japan has committed so many assets to equities that it has come to dominate that country’s exchange-traded-fund market. I have long maintained that our Fed, either directly or, more likely, indirectly, has been supporting U.S. stock prices at strategic moments.

This historic stimulus, which continues at an aggressive pace in Europe and Japan, has created unprecedented levels of debt worldwide. For more than the past century, the major countries of the world have experienced GDP growth at far faster rates when national debt has been low rather than when high. This paradox places a major hurdle in front of the world economy as it struggles to grow in an era of unprecedented debt burdens.

Let us revisit the “bet” which I have discussed in each of our last two Quarterly Commentaries. It is a fact that stock prices have always ultimately reverted to their fundamental means. At valuation levels far out of synch with underlying fundamentals, today’s portfolio values are at substantial risk should that reversion happen quickly. That outcome is the safe bet, at least in the long run. On the other hand, the central banks of the world are on an eight-year run in which they have been able to overcome weak fundamentals with an avalanche of new money and other market-supportive stimulus. It is not unreasonable to bet that central banks will remain both willing and able to keep market prices aloft. Unless the current instance permanently flies in the face of historic reality, however, profiting from equity purchases from current levels will demand that markets continue to rise before suffering substantial losses, and investors will have to make a timely sell decision before prices eventually decline to align with underlying fundamentals.

Let me introduce a few more conflicting items for your consideration. All but very short-term technical conditions continue to look reasonably bullish. Supply /demand and advance/decline figures still offer the probability of further equity price advances over the intermediate term. And while the Fed has begun to “normalize” its monetary policy in very gradual steps, it is unlikely to abandon its support of investment markets should other factors begin to put meaningful downward pressure on prices. On the other hand, the thirteen Fed rate hike cycles since World War II have led to ten recessions, a 77% rate. And, without making a political statement, every new Republican administration since Ulysses S. Grant’s (14 in all) has been in recession within two years of its inauguration. Interestingly, most experienced significant market advances from election day into the administration’s early months, as is currently the case. Complicating matters even further, both U.S. and Russian warships are steaming into contentious waters. Obviously there exist a great many highly unpredictable crosscurrents.

I’ll refer once again to the wisdom of Warren, listing two more of Buffet’s famous aphorisms: “Most people get invested in stocks when everyone else is. The time to get invested is when no one else is. You can’t buy what is popular and do well.” And: “Be fearful when others are greedy and greedy only when others are fearful.”

Such advice gets difficult to follow when abnormal conditions persist for years. It is important to remember that inevitable reversions to fundamental means can take back many years of profits. Most recently, the 2007-09 decline took stock prices back to 1996 levels, eliminating 13 years of gains. It’s critical for all investors in pursuit of profits to evaluate carefully their individual financial and psychological ability to withstand risk and losses, especially if markets should go through extended periods of weakness.

A friend sent me second-hand notes of a recent talk by Dr. Arthur Laffer at the University of San Diego and requested my comments. I sent him the following.

One quick anecdote. When I headed a not-for-profit consulting office in the late-1970s in Washington, DC, a politically connected contact of mine asked if there were anyone in Washington that I particularly wanted to meet. I told him Arthur Burns, then Chairman of the Federal Reserve Board. He couldn’t get Burns, but he sent Art Laffer to my office, and we chatted for about an hour. That was a few years after he famously sketched the Laffer Curve on the back of a napkin.

Regarding his forecast of a coming economic boom, while anything is possible, such a boom is facing formidable headwinds. Let me comment on the four pillars of Laffer’s argument, as spelled out in the notes.

Laffer is a staunch conservative, and he may be taking a political shot in saying that the Obama economy is the lowest bar in history. True, the past eight years have marked the slowest recovery from recession since WWII, but the economy has been growing over that entire period, albeit slowly. The economy today is far healthier than in 2008 when unemployment was very severe, the housing market was in shambles, and most major banks were insolvent, surviving only by the grace of a government rescue. Obama inherited an economy in serious recession, and while growth has been slow, it has been growth. Throughout U.S. history, there haven’t been many growth periods that have lasted longer, so for this to be the beginning of a boom period, it would have to break historic precedent in terms of longevity.

Laffer’s contention that all powers are in line (President, House, Senate, Supreme Court, lower courts, etc.) is questionable. Despite having legislative majorities, the Republican administration is encountering resistance within its own party. There’s been less than unanimous enthusiasm for the first iterations of the attempted Affordable Care Act revision. With economists of various stripes warning of potential negative economic consequences resulting from tighter immigration policies, unanimity in that area appears unlikely. There is already healthy debate about the wisdom of a border adjustment tax. A worst-case consequence could be violent retaliation, resulting in the kind of trade wars that prolonged and exacerbated the Great Depression of the 1930s. The prospect of significant fiscal stimulus has already aroused concern among right-leaning Republicans, many of whom have cut their political teeth as debt and deficit hawks. Many will not likely fall in line as good soldiers in the fight for fiscal stimulus. That the courts are not completely in line seems evident from the initial ruling against the administration’s first efforts at immigration restriction. The President’s characterization of a “so called judge” is unlikely to win friends among the judiciary.

Laffer’s third point sounds like his first, that the runway ahead is a long one because we’re starting from a rock bottom economy. See my earlier comments.

Tax cuts, to the extent that they are passed, will likely provide a boost to corporate earnings. And Laffer has long been a believer that such an event will turbocharge the economy. I’ve not spent any significant amount of time studying the effect of tax cuts through history, but I have certainly heard arguments that the hoped-for results have fallen far short of expectations. It’s incontrovertible, however, that government actions in the aggregate – tax changes, governmental spending and central bank activity – have produced inexorably rising levels of debt. In this country, and in most of the world, debt burdens have risen well beyond the levels that have preceded major economic slowdowns over many centuries. In This Time Is Different, Reinhart and Rogoff spell out in copious detail the deleterious economic consequences that predictably follow explosive debt growth. Invariably, populations experiencing excessive debt hear detailed explanations about why “this time is different,” and why such debt is not a serious threat. Reinhart and Rogoff maintain that history demonstrates clearly how such thinking is typically penalized severely.

In the summary of Laffer’s talk that you sent, he apparently argues that California will be a prominent non-beneficiary in this coming economic boom. If California is failing and failing quickly–“circling the drain” as Laffer put it–this will prove to be a very significant headwind facing the national success story. It’s hard to imagine a national boom with the country’s largest economic component (13.3%) stagnating.

As I said earlier, anything is possible, but Laffer’s contention flies in the face of probability on several counts. Since I was not at the talk and am reacting only to the notes taken, you have to evaluate the accuracy of the note-taker. There could, of course, be nuances not reflected in his notes.

The year 2016 was a year like few others. In the hours immediately following the closing of the polls in November, major stock indexes were trading below 2015 year-end levels. As sentiment turned on a dime from fear of a Trump presidency to celebration of the prospect for new business-friendly policies, stock prices surged over the ensuing five weeks. Interestingly, bond prices experienced exactly the opposite reaction, plummeting over the five weeks following the election. The money investors made in stocks was erased by the money lost in bonds.

Just a few months earlier, investors were faced with the greatest dichotomy in the history of financial markets. Interest rates were hitting record lows while U.S. stocks were just below record highs. As I wrote in our October Quarterly Commentary, bonds were pricing in Armageddon, while stockholders were pushing prices of the majority of stocks to unprecedented levels of overvaluation. As I write today, those extremes have only slightly moderated.

Third Longest Equity Rally

While bond prices, especially of longer maturity bonds, have been pummeled over the past two quarters, U.S. stocks continue to trade near all-time highs. We are, in fact, experiencing the third longest stock market rally in U.S. history, now more than seven years and ten months long. There is a commonly-voiced bullish argument that bull markets don’t die of old age. That is probably true, but a close reading of history demonstrates that as bull markets lengthen, more and more people buy into the bullish rationale being voiced by analysts and commentators. After all, as those analysts convincingly argue, market prices are proving their theses. And bearish cautions are backhanded away as the bleating of worrywarts who have been wrong for years. This explains why so many investors buy near market highs, the point at which the bullish case has been most persuasively demonstrated. Extended market rallies provide ample time for the accumulation of excesses that ultimately are the most proximate causes of major market tops.

It is instructive to examine the outcomes of the only U.S. market rallies that have outlasted the current one. The longest spanned almost the entire decade of the 1990s, covering the nine years and five months preceding the market peak in early 2000. A painful 50% decline marked the onset of the new century, followed by an explosive rally and another destructive decline, leaving prices 57% below their early 2000 highs in early 2009. The only other U.S. equity rally to exceed the length of the current advance lasted just a few weeks longer, topped in 1929, ushered in the Great Depression and bottomed in 1932 with stock prices down 89% from their peak less than three years earlier. In other words, we have no example of a rally lasting this long that did not immediately precede a severely damaging, long lasting price decline. The decline that bottomed in 2009 brought stock prices back to 1996’s levels, erasing 13 years of price progress. The 1929 crash that bottomed in 1932 wiped out an even longer 18 years of price history. Precedent does not dictate the future, but only the foolish would ignore a century or more of history. There may be reasons that are not obvious that limit market rallies to a shorter duration than we are currently experiencing.

Excesses Have Grown

As I expressed earlier, when rallies lengthen, excesses that ultimately lead to market tops escalate. Let me examine where we are today in terms of conditions that have commonly marked the end of stock market advances.

As a valuation-based firm, we always examine how much investors are willing to pay for corporate earnings, dividends, book value, sales and cash flow. An aggregate of the most commonly employed valuation measures shows the overall equity market today at the second most overvalued level in U.S. history, trailing only the extreme overvaluation that characterized the dot.com mania at the turn of the century. That bubble ended very badly. Valuation measures of the median U.S. common stock are at their most extreme ever. In other words, we’re paying more for the median stock relative to its underlying fundamentals than ever before.

Are there good reasons to expect that prospects for economic growth and corporate profits are similarly better than they have ever been before? While conditions can always change, both domestic and international economic growth rates have been significantly subpar for years despite the greatest amount of monetary stimulus ever. Corporate profits have also been stagnant for several years despite that aggressive stimulus. With problematic demographics and very weak productivity growth, it is unlikely that we are at the dawn of a new age of economic and corporate profit growth.

For centuries, in our country and throughout the world, excessive debt – personal, corporate or governmental – has contributed mightily to the severity of economic and securities market declines. Over the past few years, debt growth around the world has been unprecedented. In the United States, combined debt levels are barely off their all-time highs relative to the size of our economy. But for bankruptcies and foreclosures, which eliminated much debt, we would be at all-time highs. The world’s second largest economy, China, is increasingly being seen as a ticking debt time bomb, with its debt levels exploding upward in recent years. Major world central banks, especially Japan, the European Central Bank and England, have been flooding their economies with newly printed money, offset by an equivalent amount of debt, as though their economies were collapsing. What do they see that they’re not revealing? World debt has just reached its highest level ever at 325% of GDP. It is distressing to realize that excessive debt has been an integral ingredient in virtually every major stock market decline in modern history.

Bullish analysts and commentators like to point to the historically low levels of today’s interest rates as justification for hopes for an extension of the current, lengthy stock market advance. I believe it to be an open question as to whether one can look at current interest rates as we have looked at rates over past decades. Never before have rates been as directly suppressed by central bankers worldwide as in recent years. But rates, at least in this country, have begun to rise, and the Federal Reserve and most analysts expect them to rise sequentially over the next few years. Fed rate tightening actions have typically put significant pressure on stock prices, especially when valuations are high.

Rising interest rates, of course, are also destructive to bondholders, as prices decline when rates rise. That risk is especially relevant now, because the average bond today is at its longest duration ever, i.e., at its greatest sensitivity ever to rising rates. The quest for yield has led investors to buy longer maturity bonds in an era of historically low rates.

Weak Long-Term Equity Prospects

John Hussman and Nobel Prize winner Robert Shiller have each done intensive historical analyses of stock market performance from various levels of equity valuation. So extreme are today’s levels that their studies show the expected annualized equity return over the next 10 to 12 years to be in very low single digits. Hussman’s work dictates that a 50-60% decline in that time period would be a normal expectation. We believe that the most prudent investment policy in such an environment is to take steps necessary to prevent major declines in portfolio value in order to have plentiful buying power available when prices revert to historical means or below.

Conflicting Bullish and Bearish Conditions

While valuations, debt levels, the longevity of the current rally and rising interest rates all strongly suggest caution, most stock market technical conditions remain at least moderately bullish. While momentum has slowed, far more stocks are still advancing than declining, and supply and demand figures remain bullishly configured. Over many decades, growth in supply typically precedes major market tops by several months. A dangerous buildup of supply is not yet obvious.

We find ourselves in a very confusing environment. Notwithstanding more minor advances and declines, the technical conditions that normally precede a major decline do not yet appear to be in place. On the other hand, fundamental conditions that presage very severe market declines are very much in evidence. Even those who agree with that evaluation of the evidence may be tempted to try to squeeze a bit more out of this rally. And that approach could succeed. It is important to recognize, however, that adding to stock holdings at current levels will prove profitable only if prices never again dip below today’s level or if prices go higher and sales are strategically timed before a later decline.

Normal outcomes could also be dramatically altered by an economic, military or political shock. In an environment of polarized political feelings in this country and around the world, the risk of such a surprise is hardly inconsequential. Investors need to evaluate carefully their individual ability to assume such risks.

The powerful post-election stock market rally has turned a great many skeptics into hopeful, if not confident, speculators. And while momentum should never be discounted, there are numerous reasons to pay close attention to contrasting risk and reward possibilities.

Events of the past several months—the Brexit vote, the Trump election and the Italian referendum— have cast grave doubt on the predictive accuracy of the world’s major pollsters. Such surprise results have emboldened those looking for outlier outcomes. And while low probability outcomes will periodically occur, oft-repeated precedent is a far safer bet. Let’s examine today’s stock market conditions on a probability scale.

Many market commentators have dubbed the recent strong rally in U.S. stocks the “Trump rally”, and there can be no doubt but that many people have strong expectations that proposed regulation reduction, tax cuts and foreign profit repatriation will do marvels for corporate profits and, in turn, stock prices. They have either ignored or downplayed the potential negative economic effects of proposed tariffs and more restrictive immigration. However the interplay of those factors may unfold, it is unlikely that many proposed changes will have an immediate significant effect. And while Trump will have a Republican majority in both houses of Congress, a sizeable number of far-right members of his party have developed their political careers on the principle of reduced debt and deficits. It seems highly unlikely that they will find massive infrastructure spending an appetizing prospect.

The most optimistic bulls seem to believe that Trump brings to the presidency a “can do” spirit that will overcome objections on such mundane grounds as excessive debt. Many project parallels to the positive effects on the economy and the stock market that unfolded through the eight-year presidency of Ronald Reagan. While similar results could happen, dramatically different conditions exist today than at the beginning of the Reagan years.

The excellent Ned Davis Research Group outlined several striking differences between the two eras. Reagan lowered the top income tax rate from 70% to 28%. That same potential doesn’t exist today with a top tax rate of 39.6%. Inflation was in double digits when Reagan took office but had begun its steep plunge to low single digits through most of the Reagan years. Trump inherits low single digit inflation, which the Fed and all major world central banks are trying to push higher. Having flooded their respective economies with freshly minted money, countries around the world face the potential of surging inflation if disinflationary forces fade and extreme money creation produces its historically normal result.

Interest rates declined through most of the Reagan years, but Trump appears ready to assume office with rates rising and forecasted to rise further by the Fed and almost all private forecasters. Government debt was below $1 trillion when Reagan took office. It will be more than 21 times that amount when Trump takes the oath of office. With debt at such an extreme level, rising interest rates could have a devastating effect on the nation’s finances.

At the beginning of the 1980s, Reagan inherited a stock market that had been suffering through a long weak cycle since the mid-1960s and was trading at extremely low levels of valuation with price to earnings ratios in single digits. By contrast, Trump takes office after eight years of a central bank-fueled stock market rally that has pushed U.S. broad market valuation levels to the second highest ever, trailing only those of the dot.com era at the turn of the century. Today’s median stock is at its greatest valuation extreme ever.

Throughout global history, extreme levels of overvaluation have always returned to long-term norms by price declines, not by underlying fundamentals rising to meet elevated prices. In the current instance, however, central bankers have successfully prevented stock prices from reverting to their historic means by verbal intervention and by unprecedented monetary largesse whenever prices appeared to be in danger of more than a moderate decline. Investors are left with what we have characterized as “the bet”: a) whether to count on continuing central bank success in supporting overvalued stock prices or b) to expect a reversion of stock prices to their historic norms.

We continue to urge investors to evaluate not just the probability of rising or falling prices but also the potential degree of increase or decrease. While there is no way to know how high a price ceiling might be, more than a century of data indicates that the growth potential over the next decade from even lower levels of valuation is minimal. On the downside, when valuation excesses have been unwound in the past, many years of profit have been erased. Most recently, the 57% stock market decline from late-2007 to early-2009 took prices back to 1996 levels. Earlier market declines eliminated even more than 13 years of gains. Retreats from severe levels of overvaluation can be devastating, no matter how long deferred.

Returning to more immediate matters, the current post-election rally is normal, although stronger than most. Roughly 80% of the time, stocks rally from election day to the new president’s inauguration. That pattern, however, has not typically foretold a continuation of the rally. The first year of the four-year election cycle is on average the weakest, especially in the second half of the year. Over the past 80 years, post-inauguration weakness has been especially pronounced when Republican presidents have succeeded Democrats, although the sample size of four is very small. The average decline from inauguration through September of the first year has been about 13% in the Eisenhower, Nixon, Reagan and Bush administrations. While the full eight years of the Reagan presidency saw good gains, the early years included a recession and a 25% market correction. In fact, every Republican president in the past 70 years, with or without a majority in the House and Senate, experienced a recession in the first two years of his presidency. A recession with valuations anywhere near today’s levels would likely lead to severe stock market losses.

With U.S. stock prices close to all-time highs and investor sentiment improving, it’s hard to imagine a drastic change in the near term. And, frankly, many technical readings of supply and demand and new highs and lows point to likely higher prices in the months immediately ahead. That makes “the bet” both confusing and dangerous. Nobody likes to miss upside opportunities, but when stocks are severely overvalued, an unexpected economic, political or military event can crush stock prices very quickly. The most dramatic example of a sudden change of sentiment and market direction followed the 1928 election of Herbert Hoover. The new president was seen to be an excellent candidate to continue the strength of the Roaring Twenties, and stocks jumped by double digits between election day and his March 4 inauguration in 1929. Positive sentiment continued for a few more months only to be extinguished late that same year by the most devastating stock market crash in this country’s history. Thus began the Great Depression of the 1930s, exacerbated by isolationism and protectionism, which led to widespread trade wars. President-elect Trump and politicians worldwide are campaigning on nationalistic themes that were direct forerunners of the trade wars that crippled world trade in the 1930s. The dangers are there again today. We can only hope that the world will not proceed too far down that potentially destructive path.

Adding to stock holdings at current levels will prove profitable only if prices never again dip below today’s level or if prices go higher and sales are strategically timed before a later decline. Neither is a high probability option.

At our annual client conference on October 6th, we were pleased to host a large number of guests. I presented what I believe to be the most important issues I have addressed in my 47 years in the investment business. While I will reprise those comments here in necessarily abridged form, we would be pleased to provide annotated copies of the conference’s presentation materials on request.

Investors today are faced with the greatest dichotomy in the history of financial markets. Interest rates are hitting record lows while stocks are near record highs. Bonds are pricing in Armageddon, while stockholders have pushed prices of the majority of companies to unprecedented levels of overvaluation.

The Bet

This unique paradox forces investors to make a critical bet. I use the word “bet” advisedly, because the resolution of the bet, at least over the next year or two, depends on factors independent of traditional investment analysis.

Investors have to choose between the following alternatives:

Worldwide, stocks and bonds are more overvalued than ever before, yet global economic growth is scarcely above recession levels. If stock and bond prices revert to their historic valuation means, portfolio values could fall precipitously and stay down for years. Throughout history, prices have always ultimately reverted to their means.

Our Federal Reserve and other central banks around the world are flooding their respective economies with newly created money. For the past 7 ½ years, central bankers have overcome weak fundamental conditions, while stock and bond prices remain near all-time highs. This could continue.

Central Bankers Good For Stock Prices

At least ostensibly, historic levels of central bank stimulus have been designed to boost the economy and stabilize the currency with about a 2% level of inflation (to lessen the negative effects on overindebted companies and governments). Unfortunately, while that stimulus has had extraordinarily powerful effects on stock and bond prices, it has done precious little for the underlying economy.

The positive effect of the various iterations of the Fed’s quantitative easing efforts is obvious when a graph of stock market prices is overlaid with one that traces the growth of the Fed’s balance sheet. Since 2009, stocks have powered higher each time the Fed has authorized additional money creation. Yet stock prices have fallen from 13% to 17% at the end of each quantitative easing episode, only to have the declines halted by new central bank reassurance that monetary authorities stood ready to continue to support securities prices as needed. In recent months, individual central bankers have quickly voiced their support to halt declines of as little as 2% or 3%, as though afraid that their entire monetary experiment will unravel if equity prices experience a significant decline.

Can This Continue?

Any analysis of the potential for the vast collection of domestic and international stimulus efforts continuing to work should include former Fed Chairman Alan Greenspan’s comments:

“This is an unprecedented period in monetary history. We’ve never been through this. We really cannot tell how it will work out.”

I don’t think it’s possible for the Fed to end its easy-money policies in a trouble-free manner.

Negative Interest Rates

Normal central bank tools, even carried to historic extremes, have neither lifted economies, nor raised the level of inflation. European and Japanese central bankers have even resorted to negative interest rates to rev up their economies and inflation.

Today, there are over $15 trillion in negative yielding securities worldwide. Even corporate bonds have begun to show negative yields. One commentator recently indicated that 16% of European Union investment grade debt is trading at negative yields. The holders of such bonds are guaranteed to lose money if they hold the bonds to maturity. The only way to realize a profit is for interest rates to go even further negative and for the investor to sell the bonds at that lower yield. That is an incredible condition and threatens the viability of many banks and insurance companies. And unless circumstances change dramatically, many pension plans will fall far short of meeting promised retirement benefits in the years ahead. This shortfall could have immense negative consequences for the broader economy.

Negative interest rates have yet to improve the economic outlook where implemented. Ironically, in almost every country in which central banks have moved interest rates into negative territory, equity prices have suffered.

Central Banks Buying Stocks

Having tried virtually everything else without apparent success, a few central banks have decided to buy stocks, hoping that the resulting wealth effect would boost the overall economy. Japan has been the most aggressive buyer, with China, Hong Kong, Israel and Switzerland actively participating, the latter possibly as a surrogate for others (perhaps the US). The European Central Bank has recently speculated about buying stocks. Within the past month, Fed Chair Janet Yellen floated a trial balloon about our Fed buying corporate bonds and stocks, ostensibly to help in an economic downturn — a disastrous idea on so many levels! When will Congress step up and rein in the Fed, which has assumed powers far beyond what was ever envisioned when they established the central bank in 1913?

Costs of Central Bank Intervention

All this economic masterminding comes at a cost. In its first 95 years of existence, the Fed grew its balance sheet to a bit over $800 billion. In the past eight years, the Fed has grown that debt level to five times what it had taken nearly a century to produce. This is our generation’s gift to our grandchildren and their grandchildren. But all this financial legerdemain has produced record stock and bond prices for this generation. Can they be sustained?

Risks To Bondholders

On the bond side, risks are that interest rates rise and/or companies or countries default. If interest rates rise, as is inevitable eventually, a great deal of money can be lost, even in very creditworthy bonds. The ten-year US Treasury note, for example, trading today at 1.79%, would provide a negative total return for a year with a rate increase as little as a quarter of one percent. Many investors shrug off such concerns, because they expect to hold their fixed income securities to maturity. And certainly, if the issuing company or country does not default, the investor will get back principal and interest. There is however, no guaranty of what that money will buy at maturity. In the last rising interest rate cycle extending from early 1941 to late 1981, for example, a typical portfolio of government and corporate bonds lost over 2% of its purchasing power per year despite collecting regular interest payments. Even unmanaged, risk-free US Treasury bills outperformed almost all bond portfolios for more than four decades. Investors apparently do not recognize the dangers as they pour extraordinary amounts of money into bonds at historically low interest rates. They can’t buy yesterday’s performance, only tomorrow’s.

Risks To Stockholders

On the equity side, dangers lurk in several areas. As indicated earlier, the majority of stocks are at their most overvalued levels ever. When calculated by a composite of the most commonly employed valuation measures, the entire market is at its second most overvalued level, slightly behind valuations in the dot.com era at the turn of the century.

It is ironic that investors are so enthusiastic about stock ownership with the US and world economies sluggish and in many instances slowing. Just weeks ago, the International Monetary Fund lowered its global growth forecast to 3.1% for 2016, a number they have been steadily lowering. This is barely above recession level for world growth. The Federal Open Market Committee of the Federal Reserve Board also recently dropped its estimate of long-term US growth to 1.85%, the lowest level on record. Despite unparalleled stimulus, the US continues in the slowest recovery from recession in three-quarters of a century.

Not surprising in a weak economic environment, corporate profits have been declining year over year for the past five quarters. And measured on a Generally Accepted Accounting Principles basis, profits are approximately back to 2007 levels. Over the past six quarters, profits have fallen by about 20%. Thanks to central bank support, stock prices are up in that time period.

Declining earnings growth is not limited to the US. According to Goldman Sachs, world earnings per share have increased over the past decade by less than 2% per year. On average, European countries have actually seen earnings per share decline by more than 2% per year over that decade.

Debt A Threat

Those who have attended our conferences or who have read our commentaries over the years know that I consider extreme levels of debt in almost all major countries around the world to be the single most dangerous threat to our long-term economic wellbeing. In recent years, dramatically growing debt levels, on top of already excessive debt loads, have been controlled by central bankers piling on even more debt while effectively printing previously inconceivable amounts of new money. History argues convincingly, however, that for centuries countries with debt levels even lower than most today have suffered extended economic malaise, often accompanied by significant inflation and severe market disruptions.

Investment Stars Voice Warnings

Over the past few months, some of the most successful investors of our era have sounded alarms about the danger in today’s markets. Stanley Druckenmiller, whose hedge fund produced 30% per year returns for 25 years before closing to outside money in 2010, summarized his concerns with: “Get out of all stocks.” George Soros, a hugely successful hedge fund pioneer, returned to investment management from philanthropy to take advantage of opportunities on the short side. He sees “a serious challenge which reminds me of the crisis we had in 2008.” “The world is running into something it doesn’t know how to handle.” Jeff Gundlach, CEO of DoubleLine Capital, a very successful bond manager, recently counselled: “Sell everything. Nothing here looks good. Sell the house. Sell the car. Sell the kids.”

So far, those concerns have not played themselves out in US markets. Equity prices in most other countries, however, have moved appreciably lower than they were at their highs a year and a half ago.

But More Stocks Going Up Than Down

Notwithstanding all those negatives, many more stocks in the US have been advancing recently than declining. And markets generally show a marked deterioration in such advance/decline figures before forming major tops. To this point, central bankers continue to prevail.

Mission’s Approach

Where does Mission stand? As a deep discount value manager, we won’t bet heavily on the more speculative “central bank winning” side of the bet. We are, however, willing to increase the risk-assumption level of any portfolio for clients who want that exposure. We have, though, been in a similar position twice before in the past two decades where we leaned against the prevailing trend and ended up benefiting our clients handsomely.

At the turn of the century, we warned aggressively that equity prices were on thin ice because of the unhealthy combination of extreme levels of debt and unmatched levels of overvaluation. The vast majority of our clients employed our Risk Averse strategy, which targeted absolute, rather than relative returns. Equity prices began a major decline in 2000. Despite our concern with the overall market level, our bottom-up individual stock selection process found quite a few stocks that met all our purchase criteria. Over the 2 ½ years from April 1, 2000 to September 30, 2002, Mission’s average client portfolio grew by over 17% while the S&P 500 declined by almost 38%, including dividends paid. Mission’s stocks actually rose while most stocks fell precipitously.

By 2007, amidst massive speculation and the never-to-be-forgotten housing bubble, we were far more defensive than in the earliest years of the new century, but still finding some stocks that met our purchase criteria. The S&P 500 plummeted by more than 50% from November 1, 2007 to February 28, 2009. Mission’s stocks lost money also in that horrendous decline but nowhere near as much as the S&P 500. Because we had cut back so substantially on our risk exposure, our clients emerged from that excruciating bear market with a total portfolio loss of less than 1%.

Because we did not believe that the weak cycle that began in 2000 had ended, even after the initial 2000-02 bear market, we remained cautious and had limited risk exposure during the strong stock market rally up to the peak in 2007. That caution was eventually rewarded, as we avoided the portfolio decimation that many investors experienced in the 2007-09 decline. In the almost nine-year period from early-2000 to early-2009, Mission’s risk-averse portfolios outperformed the S&P 500 by 10.6% per year.

As a manager that bases investment decisions on proven, historically sound data, Mission has been unwilling to assume significant market risk since 2009, a period in which, in retrospect, risk assumption was well rewarded. Central banker largesse has overcome far below normal fundamental data and Mission has lagged behind those willing to accept substantial risk. If central bankers win “the bet”, it’s unlikely that Mission will keep pace with more aggressive managers. On the other hand, if history plays out as it always has before, I expect Mission will again catch and pass those assuming substantial risk in the current, very dangerous environment.

Consequences As Well As Probability

While we can’t know the probability, at least in the short term, of which way the bet will be resolved, it’s important to evaluate the potential consequences of whatever the outcome might be. On the upside, we know what historically normal returns have been: about 10% per year for stocks, 5+% for bonds and 3.5% for risk-free cash equivalents with inflation about 3%. These are 90 year averages, and, logically, they are computed from average levels of interest rates, valuations and economic conditions. Today, not one of those conditions is average or normal, and because of that, we’re not likely to experience historically normal returns over the next few years.

On the other hand, there is significant danger to both stocks and bonds should investor faith in central bankers falter. If investors begin to doubt either the willingness or effectiveness of central bank efforts to keep stock and bond prices aloft, a nonsupportive air pocket exists below current stimulus-supported levels. Not knowing the details of market history, most investors underestimate the damage that major bear markets can inflict. The most recent serious decline that ended in 2009 brought stock prices back to their 1996 level, erasing 13 years of price gains. That drop was actually less painful than the carnage unleashed by three prior US bear markets which erased price gains of 16, 18 and 28 years. The bear market that began in Japan at the end of 1989 leaves prices today at levels of three decades ago.

Because markets have bounced back so robustly from the two precipitous declines since 2000, many investors have lost their fear of big declines. It is important to recognize that those rebounds were precipitated by unprecedented government support. And government may be running out of ammunition. It is sobering to recognize that prior to the last two major declines, it took 12, 16 and 24 years for stock prices to permanently exceed the price peaks at the beginning of the three big bear markets in the mid-to-late 20th century.

The Investor’s Dilemma

Every investor and investment manager has to decide how much of each side of the bet to accept. If you choose to align yourself with underlying economic and market fundamentals, yet prices continue to rise in response to central bank stimulus, you’ll inevitably wish you had assumed more risk. If, on the other hand, you bet on central bankers and market conditions revert to their means as they always eventually have, you may be nursing portfolio wounds for years to come. Any individual’s or organization’s ability to withstand such a risk undoubtedly depends on the depth of current resources and future earning power. As indicated earlier, Mission will not bet heavily on central banks winning for any further extended period of time. We may assume controllable risks on a strategic basis, but we anticipate that the next significant opportunity to profit from substantial stock and bond holdings will come with patience and at far more attractive valuations. That approach has proven extremely beneficial twice since 2000, and we believe that the probabilities lie heavily on the side of at least one more repetition until the debt and valuation excesses are significantly reduced.

Notwithstanding brief periods of weakness, both stock and bond markets have experienced remarkable success for more than seven years running. Through that period, those who have continued to highlight various dangers as reason for caution have been perceived as boys who cried “wolf”. Copious quantities of newly printed money have flooded the equity and fixed income markets, keeping prices at elevated levels. Those without much investment experience or historical perspective might view this phenomenon as normal or in some way the birthright of investors willing to accept market risk. Nothing could be farther from the truth.

Informed investors must recognize the monumental bet they are making. (And I use the word “bet” advisedly.) Positive returns remain possible over the next few years if the Fed and other world central bankers remain willing and able – two separate considerations – to keep stock and bond prices elevated. Confidence in their price support has been a winning bet since 2009. Traditionalists who believe that fundamental conditions will prevail, as they always ultimately have, see great danger in the extraordinary combination of slow economic growth, stagnant corporate earnings, extreme overvaluation, suppressed interest rates and unprecedented debt levels. Reversion to historic means could produce destructive losses. In my nearly half century in the investment industry, I have never before seen such a clear divergence between underlying fundamentals pointing in a negative direction and powerful central bankers aggressively promoting higher securities prices.

In a May article, “‘Normal’ Returns Are Unlikely In A Far From ‘Normal’ Environment,” I outlined the extraordinary economic and market conditions that make historically normal returns highly unlikely. By way of quick summary:

Risk-free cash equivalents have provided an essentially zero return for the past eight years.

Longer fixed income securities are at all-time low yields throughout most of the world. Over $11 trillion of securities now trade at negative yields.

Common stocks are near all-time valuation highs, second only to the period around the dot.com mania peak, from which point stocks were trading more than 50 % lower nine years later.

The US and world economies are extremely slow. The IMF, OECD and World Bank all continue to ratchet down their estimates of domestic and world economic growth. The US remains in its slowest recovery from recession in three-quarters of a century.

Corporate profits in this country are essentially unchanged from four years ago, despite stock prices having progressed significantly higher. Earnings and revenue estimates have been far too optimistic for several years.

Debt levels in the US and around most of the world are extreme and dangerous. Current debt levels are far above levels that have led to significantly below normal economic growth throughout history.

Having appraised this confluence of precarious conditions, two of the greatest living investors have turned decisively bearish. Stanley Druckenmiller, whose hedge fund returned 30% per year for a quarter of a century before being closed to the public, indicated recently his belief that investors should sell all stocks and own gold. George Soros, one of the legendary early hedge fund operators, recently returned to money management from philanthropy. Soros believes that opportunities on the short side are sufficiently attractive to draw him back to his earlier extremely profitable pursuit. He also expressed his currency preference to be gold. In addition, just weeks ago, Goldman Sachs did the unthinkable for a major investment firm, saying that it could see no reason to own stocks. Druckenmiller, Soros and Goldman Sachs could all be wrong, but, at the very least, it should be a sobering consideration that they all see great risk in the stock market.

Reversion to the mean has been a process that has characterized securities markets throughout history. At current levels of overvaluation, it is logical to expect that significant price declines may realign stock and bond prices with underlying fundamentals. There is, however, another long-appreciated aphorism, widely attributed to John Maynard Keynes: Markets can stay irrational longer than you can stay solvent. In other words, while markets will almost certainly mean revert, they might not do it on your timetable. That, again, frames the bet investors must make: Do you bet on historically normal mean reversion, leading to a highly defensive stance, or do you bet on a continuation of central bankers’ successful exercise of experimental monetary policies?

Factors in any risk-assumption analysis are not just the probability of one outcome or another but also the consequence flowing from each alternative. With interest rates at multi-century lows, the potential return from fixed income is not only severely limited, there is a possibility of substantial losses if interest rates should rise rapidly. For all the factors profiled earlier, while stocks could still advance, it is highly unlikely that they will make dramatic gains. On the other hand, having declined by 50% or more twice already in the past 16 years, equities could repeat such aggressive bear market behavior if investor confidence in central bankers should wane.

With upside potential limited and downside risks substantial, maintaining traditional portfolio allocations and the widely followed buy and hold approach is likely a prescription for substantial portfolio damage in the years ahead. Organizations and individuals with little potential to replace lost capital should be particularly careful about betting on continuing central bank success.

Almost all investors have at least a general familiarity with the long-term performance record of stocks, bonds and cash equivalents. Over the 90-year span from the end of 1925 to year-end 2015, common stocks provided an average annual total return of 10.0%; Intermediate U.S. Government Bonds 5.3%; and risk-free U.S. Treasury Bills 3.5%. All this transpired in an environment marked by an average inflation rate of 2.9% per year. Substituting corporate bonds or long-term U.S. Governments would increase the volatility of fixed income returns but do little to change the 5.3% long-term return provided by Intermediate U.S. Governments. Deducting inflation reduces average real returns to 0.6% for cash equivalents, 2.4% for bonds and 7.1% for stocks over the 90 years studied.

If we could count on such average returns over any upcoming five- or ten-year period, portfolio construction would be decisively simpler. Over the decades, however, history has taught us repeatedly that many factors conspire to make decision-making very difficult. Performance of the major asset classes frequently varies dramatically from long-term averages, occasionally for extended periods of time.

Most investors are astounded to learn that risk-free cash equivalents have outperformed both stocks and bonds for several very long periods of time. Over more than half of the twentieth century in three distinct stretches (1903-20; 1929-49; 1966-82), unmanaged risk-free cash equivalents outperformed common stocks. And for more than 40 years from the early-1940s through the early-1980s, cash equivalents also outperformed a typical broadly diversified bond portfolio.

Unfortunately, no one is kind enough to ring a bell announcing the inception of those lengthy periods of stock and bond underperformance. We have to examine available evidence to determine whether we should expect historically “normal” returns or, perhaps, something very different. Evaluating today’s conditions, we see little that looks “normal”.

Thanks to the Federal Reserve, risk-free return has been essentially non-existent for eight years, robbing the elderly retired of any return if they were unable or unwilling to accept the investment risk of other asset categories. This is not only not “normal”, but unprecedented, with the yield below even the minimal risk-free returns of the Great Depression.

The yields on longer fixed income securities are not appreciably better, resting at or near all-time lows throughout most of the world. Many have absurdly descended into negative territory, thanks again to the geniuses at work in a number of central banks. At such levels, yield is non-existent, profit potential severely limited and risk levels extremely high. Nothing “normal” here.

Common stocks are currently priced near all-time valuation highs. A composite of commonly employed valuation measures (stock market capitalization relative to the size of the economy, price-to-dividends, price-to-book value, price-to-earnings, price-to-sales and price-to-cash flow) is higher than ever before in U.S. history but for the period immediately around the dot.com mania at the turn of the century. From that price peak, stock prices were more than 50% lower nine years later. Nobel Prize winner Robert Shiller’s research, covering the years since 1881, demonstrates clearly that far below average returns consistently follow periods of far above average valuations. From current levels of valuation, “normal” real annual returns over the next decade or more are likely to be either negative or low single digit positive. If history repeats, that period is also likely to encompass at least one major stock market decline, which could be similar to the two that we have experienced so far in the still young twenty-first century. “Normal” returns from such conditions are likely to be very different from the 90-year “normal”.

The U.S. and world economies are in danger of far below normal progress in the years ahead. The international Monetary Fund, the Organization for Economic Cooperation and Development and the World Bank have for several years been reducing their estimates of economic growth worldwide. That growth slowdown has been more persistent and far more severe than economists have anticipated, despite the most aggressive monetary stimulus in history. Notwithstanding some recent growth, the U.S. is still experiencing its slowest recovery from recession in more than three-quarters of a century. Reflecting a drying up of global demand, global exports have recently declined year over year, a condition occurring only during U.S. recessions in the past quarter century. Whether a recession is pending or not, it is likely that we continue to face a far below “normal” economic environment.

Over many decades, common stock prices and corporate earnings have grown at roughly the same rate, although not always in lock step. While stock prices have continued to climb, corporate profits are approximately unchanged over the past three years–far below a “normal” rate of growth. Stock prices have clearly outrun corporate earnings. Earnings and revenue guidance for the period immediately ahead is tepid at best.

The most serious ab-“normal” condition facing investors and society in general is the extreme and dangerous level of debt built up both domestically and internationally. In their attempts to rescue the U.S. and major world economies from the financial crisis and to sustain growth during the lethargic recovery, central bankers have created unprecedented levels of debt. In This Time Is Different, Carmen Reinhart and Ken Rogoff chronicle in great detail how excessive debt levels have led to extended periods of far below “normal” economic growth over many centuries in countries throughout the world. Today’s levels of debt relative to the size of most major countries’ economies are well beyond the danger points outlined in Reinhart and Rogoff’s research. And history’s greatest stock market declines have almost invariably unfolded soon after a period of extreme debt buildup.

What then are the prospects for securities over the next few years? Risk-free cash equivalents are likely to provide little over zero for some time to come if central bankers retain control. The singular advantage to cash, however, is liquidity, which buys the investor the option to take advantage of occasional dramatic price declines in other asset classes.

With yields on longer fixed income securities near historic lows, there is far more room above current levels than below. To make more than the meager coupon on today’s bonds and notes, yields have to go even lower, and investors have to make a timely sale at those lower yields. The far more likely prospect of higher rates in the years ahead will lead to a loss of principal value–a bad risk/reward equation.

Despite very slow economic growth, stagnant corporate earnings and excessive valuations, common stock prices could still move higher if investors retain confidence in the willingness and ability of our Fed and other central bankers to support the securities markets. While possible, such a scenario flies in the face of what is “normal” with today’s conditions. Add the issue of unprecedented levels of domestic and worldwide debt, and normal corrective price moves could be powerfully magnified.

Short-term traders may be able to navigate such turbulent waters, although very few hedge funds have done that successfully in recent years. Buy and hold investors face particularly difficult prospects. It is not inconceivable that a reversion to “normal” valuations could cut stock prices in half or more, as has happened twice since year 2000.

Many buy and hold investors expect to survive such episodes, painful as they may be, by just staying the course. After all, that’s been a successful formula in this country during today’s investors’ lifetimes. It may be instructive, however, to look to Japan for cautionary guidance. At the end of the 1980s, the Japanese stock market was the biggest in the world. It had been rising inexorably through that decade, as Japan had come to dominate the automotive and electronics industries. Japan appeared to have the new industrial paradigm. As the excesses of their prior long strong cycle began to unwind, however, stock prices began to fall. So ab-“normal” were conditions that prices ultimately declined about 80% and today, more than a quarter century later, remain more than 50% below the 1989 peak. No one could have foreseen such an outcome when the Japanese market was near its top.

The fixed income portion of portfolios could simultaneously be damaged severely if interest rates should revert to historically “normal” levels. Should inflation rates also return to “normal”, the purchasing power of bond proceeds at maturity would be markedly compromised.

There is no easy pathway to investment success in the years immediately ahead. As long as central bankers retain control, traditional approaches may continue to provide some success. Should current rates, valuations and conditions revert to historically “normal” levels, however, traditional approaches may be severely punished. In such an environment, avoiding major losses may become as important as seeking gains. Even very low-return cash equivalents may come to play a valuable role in preserving assets so they may be productively deployed at more attractive future valuations. In both equity and fixed income areas, proven strategic approaches are likely to be far more productive than a traditionally allocated buy and hold approach. Retirees or organizations with largely irreplaceable capital should be particularly risk-averse. There is very little “normal” in the current environment.